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50 Questions: How does a VC estimate market size?

Fifteenth in a series of weekly posts by myself and Nicholas Lovell of Gamesbrief which answer the fifty questions you should ask before raising venture capital.  We expect the series to run for a year after which we will collate the posts into a book.  You can find the rationale behind the series here, and the list of questions here.  We welcome your comments on any and every aspect of what we are doing.

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image There are three things that every VC looks at when they evaluate a company, market, product and team, and I will look at each in my next three posts in the series.  The emphasis between the three varies between VC with perhaps the most important difference coming with the stage of investment.  Earlier stage investors look more to team whereas later stage investors look more to market and product, a natural reflection of the fact that for young businesses the product and market are typically evolving fast which places greater emphasis on having the right team.  With later stage businesses by contrast if you have a great market and a strong product it is less important that the team is full of A-Star players.

The first, and probably most important, evaluation of market size comes from an assessment of the problem the company solves (or entertainment value it brings) and how much people and companies will pay for the solution.  Pretty obviously, the market opportunity is comes from multiplying the number of potential customers by the amount each will pay and the first order assessment looks at how painful the problem is as a proxy for how much people will pay and how wide the appeal will be.  On the consumer side the market is usually cut by age, geography, or gender.  On the corporate side the market is usually cut by geography, industry or company size.

Sometimes at this point it is clear that market is huge and no further analysis is necessary, and on the flipside, if there is no problem being solved (or it isn’t clear) then it is unlikely that discussions and analysis will progress to the next level.

Many of our prospects fall into the middle area though – it feels like there is a big opportunity, but we want to do further work to make sure the opportunity is big enough to support a business of VC scale (note the definition of VC scale and thus minimum attractive market size is smaller for smaller funds and larger for larger funds).  In that case the next two steps are a top down and bottom up analysis.

‘Top down’ analysis is a code word for looking at what analysts like Forrester and Gartner have to say about a market.  There are two things to watch out for with top down analysis – the first is to distinguish between overall market size and the truly addressable market.  To make an analogy, if you are selling hamster food and the only analysts’ figures available are for the pet food market as a whole then the big number they are doubtless quoting isn’t really applicable to your company.  Quoting high level market size numbers like this in business plans without going on to talk about which portion of the market is truly available is a sufficiently common error in business plans that it has become a cliche.  The second thing to watch out for is that many startups are in at the beginning of new markets that analysts have yet to start covering.  In this situation the absence of a market size estimate shouldn’t be troubling, although I would expect that some analysts somewhere are saying that the market looks interesting, even if they aren’t putting a size on it.

‘Bottom up’ analysis is an attempt to calculate exactly how many people might be in the market for a given product and then what they might pay.  Sometimes the ‘how many people’ bit is quite easy – if you are an internet service provider in the UK then your addressable market is the 18.3m households that have web access here, of if you sell software to telcos your addressable market is the number of telcos in the world, but often it is more difficult than that – for many novel services it is impossible to know for sure whether the appeal will be niche or mainstream.  The second part of the bottom up analysis is estimating what people will pay – in all but the most mature markets this is difficult to do with accuracy, largely because different customers will pay different amounts, but coming to a first order approximation is usually sufficient and shouldn’t be too hard.  Data from existing customers (if any) is a critical input to any bottom up analysis.

Hopefully this gives you a sense of how we think about market size.  It is a critical part of assessing a company’s prospects, but as you can see it is an inexact science, and one of the major risks that VCs take is over market size and market timing.